EMH (Part 3): The Home Builders

We’ve looked at the Efficient Market Hypothesis (EMH) repeatedly over the years. Our conclusion has been that eventually, markets are mostly kinda efficient. Sometimes it takes years for markets to integrate all the good or bad information relevant to a given stock or market — as was the case with Apple’s iPod or with Enron’s blowup.

Over the short to intermediate terms, markets can be astonishingly inefficient. This is one of our reservations about Prediction markets — they tend to be shorter term in duration. They are more likely to run into the sorts of inefficiencies we see characterized even with widely followed companies, like Apple and Enron.

What’s been even worse, we continue to see people reaching all manners of ill-advised conclusions from the shorter duration charts of various flavors and sectors; these have the unfortunate tendency to lead the faithful astray. In the past, we have advised to "Beware Economists seeking guidance from stock markets;" the very same meme applies to traders and strategists drawing bold conclusions from very short term charts also.

Which leads us to some recent charts. Let’s take a look at the Home Builders:  Its amazing that some people claim to read charts, yet manage to draw the precisely wrong conclusions from them. Remember, since no one knows the future, all investing and trading are games of probabilities regarding any given possible outcome. We cannot expect perfection — but we can at least hope to see some measure of intellectually defendable theories.  All too often, even that modest goal is missed. 

A classic example of this misunderstanding has been the action in the Homebuilders over the past few years. For our purposes, let’s look at the bigger builders: Lennar (LEN), Toll Brothers (TOL), KB Homes (KBH), Pulte Homes (PHM), Centex (CTX), Beezer (BZH).

Our story so far: Many of the Home Builders ramped up from 2003-2005. This took place due to ultra cheap mortgage rates, utterly rampant real estate speculation, and extremely lax lending rules. Indeed, the Home Builders as a group hit their highs at the peak of the R/E market in Summer 2005. (BZH was the exception, peaking in January 2006). Given that the market is supposedly a discounting mechanism — and the stocks were cheap on a P/E basis — some people took this to mean that Real Estate was just fine, and there was no Housing slow down coming. Of course, we now know that was utterly wrong. The stocks in this sector got cut in half over the next year:

Firm High Low Recent High
Lennar (LEN) 68.66 (7/29/05) 38.66 (7/14/06) 56.54 (2/2/07)
Toll Brothers (TOL) 58.67 (7/22/05) 22.22 (7/21/06) 35.64 (2/2/07)
KB Homes (KBH) 85.45 (7/22/05) 37.89 (7/21/06) 56.08 (2/2/07)
Pulte Homes (PHM) 48.22 (7/29/05) 26.02 (7/21/06) 35.56 (2/2/07)
Centex (CTX) 79.66 (7/22/05) 42.90 (7/21/06) 56.66 (12/29/06)
Beezer (BZH) 82.14 (1/13/06) 35.96 (9/08/06) 47.60 (12/29/06)

Then came the lows over the Summer 2006. As Housing stocks rallied off of these deeply depressed levels, we (once again) heard the same types of faulty reasoning. The misinterpretation for the charts: proof that the Housing bottom was in, and that Real Estate would not be a further drag on the economy. Wrong, and wrong again.

Lastly, came the rally off of these lows. Again, cads and fools mustered this as proof that Housing was okay. As the charts below now show, that bounce is over and all of these stocks have rolled over; many have revisited their prior "bottoms," and a few even made fresh lows.

There are lessons here for those astute enough to note the difference between academic theory and stock reality. First, markets can be astonishingly inefficient, especially over the short term.  Second, drawing broad macro conclusions from these "wiggles" is a fool’s errand. Last, tops and bottoms are notoriously bad places from which to extrapolate out towards infinity.

click for larger charts







Note: The ISE HomeBuilders Index doesn’t go back far enough to be
instructive, as it began trading around June 2005 (another lesson as it came out near the peak, as often occurs with Wall Street products) We include it for the sake of completeness:


All Charts via StockCharts.com

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What's been said:

Discussions found on the web:
  1. Barry Ritholtz commented on Mar 13

    I didn’t use the sub-prime lenders as an example, as it was too easy.

  2. Winston Munn commented on Mar 13

    In these retracements off the lows, it is rather amazing how many correspond to fibonacci retracement theory, either 68.2%, 50%, or 32.8%.

    On the other side, this also exemplifies how the market for so long has been fixated on the P side of P/E. Depending on how bad this housing slide becomes, at current prices those 8 X E could be a forward P/E of 12-16 or even higher. Dylan said it best: “The times they are a changin'”.

  3. V L commented on Mar 13

    No Wonder: US Feb Retail Sales SUCK

    Consumer spending makes up about 70% of gross domestic product, which is the scoreboard for the economy.

    Sales of all retailers except auto and parts dealers fell 0.1% in February.
    Demand dropped at retail outlets selling clothes, furniture, electronics and general merchandise. February gasoline station sales rose 1.2% last month after decreasing 0.5% in January.
    Stripping away sales at gas stations, demand at all other retailers was flat in February. And excluding both the auto and gasoline sectors, all other retail sales decreased 0.3% in February.
    Sales last month fell 0.3% at electronic stores; 1.4% at building materials and garden stores; 1.2% at eating and drinking places; 0.8% at sporting goods, hobby and book stores; 0.6% at general merchandise stores; 1.8% at clothing stores; and 1.7% at furniture retailers.

  4. TempusFugit commented on Mar 13

    If you go back and read the EMH in Eugene Fama’s doctoral dissertation, it doesn’t claim that the market is always right. It only says that the typical investor with access to publically available information cannot systematically beat the market. As Pogo might have said: “We have met the market and it is us.”

  5. JKH commented on Mar 13

    Markets discount expectations on some sort of average risk-adjusted basis.

    The market is not a discounter of the actual future. It is a discounter of the expected future. Huge difference.

    The difference makes Nasdaq 5000 possible, along with every other valuation error that has occured in history, including housing stocks, run of the mill volatility, and inverted yield curves that overstay their welcome.

    Virtually all expectations are doomed to be wrong. The probability of a point estimate being correct in continuous space (or near continuous cash flow space denominated by currency) is mathematically 0 (or near 0).

    Academic efficiency is the incorporation of information in the formulation of expectations.

    Efficiency is not correctness. It includes the freedom to be temporarily wrong about the future (at least until it arrives), even with the best information.

    Market efficiency denies systematically more correct expectations from a single agent. But some expectations may still be more correct than others, some of the time.

    E.g. Conrad Black will win.

  6. TheFinancialPhilosopher commented on Mar 13

    I believe this is the key phrase in your post: “Its amazing that some people claim to read charts, yet manage to draw the precisely wrong conclusions from them.” I wholeheartedly agree but would also add that its not “amazing” that people draw the “wrong conclusions.” In fact, I believe this self-defeating behavior is quite expected. Knowledge is not wisdom; however, I find that “fools” will hurt themselves exponentially more as their “knowledge” increases. The reason may be that fools find more pleasure in displaying their “knowledge” than utilizing it themselves. If their charting strategy does not reap rewards, a fool will find another chart or strategy to display their knowledge and the self-defeating cycle is perpetuated.

    Thanks for speaking highly of EMH, the “strategy” often overlooked by “fools…”

    Kent (aka The Financial Philosopher)

  7. MikeBC commented on Mar 13

    The EMH is one of the biggest sleights of hand in modern finance theory. It completely glosses over the most important fact that what matters more than whether or not a stock eventually ends up at the “right” price (whatever that is), is how exactly the price moves to get there–and who benefits from the move when it does.
    The EMH says to the typical investor, “you can’t make money with this information because the price already reflects it” but clearly, when market-moving information hits the market, *someone* makes money off the move—the question is who? I submit that in many if not all cases, even if you assume that there is no insider trading (a big assumption IMHO), for technological and sociological reasons, the ability to take practical advantage of breaking news that will move a stock price is only possessed by a small set of institutions, ie the big investment bank/brokerage firms, who use this ability to benefit themselves and their most favored clients (i.e. the hedge funds and large private accounts) and that most small investor/trader types are generally locked out of reaping the rewards of paying close attention to the wire. Presumably, in the idealized world inhabited by economists and capital markets theoreticians, the fact that the market is “efficient” means that prices magically move from one position to the next and that the costs and benefits of the move are randomly distributed across all participants in the market for the affected security, but we all know that’s not the case.

  8. Michael Schumacher commented on Mar 13

    And continuing the “bottoming” out of the housing market….Icahn offers $22 a share for WCI. For those who don’t know WCI is highly exposed to high end florida condo’s….need I say more..


  9. Mike_in_FL commented on Mar 13

    Since it has implications for the builders, I would point out that the Mortgage Bankers Association just released its Q4 delinquency and foreclosures stats. Here’s a rundown of the data. There’s also a link to my blog, where I built a quick chart showing the history of the DQ rate going back to 1979.

    * The overall mortgage delinquency rate climbed to 4.95% in the fourth quarter. That’s up from 4.67% in Q3 and 4.7% Q4 2005. Historically speaking, it’s the highest in three-and-a-half years.

    * Subprime delinquencies jumped to 13.33%. That’s up from 12.56% in Q3 and 11.63% in Q4 2005. It’s also the highest in just over four years.

    * But it’s NOT just subprime, and it’s NOT just ARMs that are starting to show problems. Even the prime, fixed rate category showed a spike in delinquencies to 2.27%. This number had been in a tight range of 2% to 2.11% for several quarters.

    * The foreclosure rate popped to 1.19% from 1.05% in Q3 and 0.99% in Q4 2005. The last time it was higher was in Q1 2004.

    This survey covers more than 43.5 million first mortgages on 1-4 unit residential properties. It’s one of the broadest delinquency and foreclosure surveys in existence.


  10. Bob A commented on Mar 13

    Was it just last year your friendly mortgage salesman was saying “the only way you’re ever gonna make any money on real estate is on the appreciation anyway, so who cares if you’re not paying down the principal”. Who else has surprises in store. Could it be WM? Could it be WB/World Savings? Both big in option arms the last few years. hmmmm

  11. SINGER commented on Mar 13

    Check out the long term monthly charts on these homebuilders and you’ll find more Head and Shoulders than a P+G factory….

  12. S commented on Mar 13

    Cramer’s video today basically says FED rate cuts are going to save equities. Commentators made the same claim when the FED surprised the market with a 50bps cut in January 2001. High octane stock jockeys who are hard wired to buy equities on rate cuts pushed the DOW up around 300 points that day. But we know who it ended over the next several quarters.

    The credit cycle has turned. Lenders are finally waking up to the fact they’ve been grossly mispricing risk. They will pull in their horns and reduce lending to repair their balances sheets. That’s the way it always works. Rate cuts stimulate borrowers to act, not lenders.

    It’s going to be interesting to see how many of the people who eagerly sold all those credit default puts on the sub-prime lenders for a couple of hundred bps over treasurys 6 months ago honor their promises. The first real test of the credit default swap market is upon us.

  13. Lauriston commented on Mar 13

    “Remember, since no one knows the future, all investing and trading are games of probabilities regarding any given possible outcome….”

    Amen brother! Right on! Don’t tell that to Sir Alan though, he knows the future is 1/3 chance recession coming… precisely.

  14. Will commented on Mar 13

    BR — I have been reading your blog for over a year and you have been cautious/negative on housing the whole time. I hope you made a bundle on this.

  15. OldVet commented on Mar 13

    Bombs away! Hope you’re short the next couple weeks.

  16. costa commented on Mar 13

    If the fed lowers rates again how can that even be good for us?

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